July 8th, 2012
by Jeff Miller
Once again we were on target with the theme for last week -- the Friday fireworks.
The calendar quirks put a special emphasis on earnings this week, with the Alcoa "official start to earnings season" coming on Monday. There is a lot of debate about the upcoming reports and what the results will mean.
Background on Earnings and the Economy
My sense is that most traders and fund managers are economic nay-sayers. We had some fun last week at Wall Street All Stars, starting with a challenge from my colleague Bob Marcin. He thinks that decades of economic growth have been basically fueled by debt. Invited to join in, I offered some arguments on the other side. Readers might enjoy our differing perspectives, which get right to the basis of differing economic expectations.
This extends to corporate earnings, where the conventional wisdom is pretty skeptical. There have been more pre-announcements than we have seen in recent quarters, and these have been mostly negative. The reasons cited have increased nervousness about other companies that have not come to the earnings confessional.
Has the sluggish economy finally caused corporate earnings to decline? If so, by how much?
Background on "Weighing the Week Ahead"
There are many good sources for a list of upcoming events. With foreign markets setting the tone for US trading on many days, I especially like the comprehensive calendar from Forexpros. There is also helpful descriptive and historical information on each item.
In contrast, I highlight a smaller group of events. My theme is an expert guess about what we will be watching on TV and reading in the mainstream media. It is a focus on what I think is important for my trading and client portfolios.
This is unlike my other articles at "A Dash" where I develop a focused, logical argument with supporting data on a single theme. Here I am simply sharing my conclusions. Sometimes these are topics that I have already written about, and others are on my agenda. I am putting the news in context.
Readers often disagree with my conclusions. Do not be bashful. Join in and comment about what we should expect in the days ahead. This weekly piece emphasizes my opinions about what is really important and how to put the news in context. I have had great success with my approach, but feel free to disagree. That is what makes a market!
Last Week's Data
Each week I break down events into good and bad. Often there is "ugly" and on rare occasion something really good. My working definition of "good" has two components:
- The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially -- no politics.
- It is better than expectations.
Despite the negative ending to the week, there was some good news.
- Home prices are higher according to CoreLogic. Everyone paid a lot of attention to this source when prices were falling, so it is probably worth a look now. Mark Perry has a nice chart:
- Initial jobless claims were much better at 374K, down 14K from last week. The latest data did not include the survey week for the monthly employment report. Doug Short's chart, showing the data point, the widely-followed four-week moving average, and past recessions, shows why the current battle ground is significant.
- Important steps in Europe. Last week's EU Summit significantly reduces the immediate contagion threat that has affected US stocks. It improves prospects for European economic growth. It demonstrates that the process of negotiation and compromise is making some progress.
- Car sales have been very strong. This is a strange discrepancy from reported employment figures. (Via Mark Perry).
- Central banks did some rate cutting (ECB and China most notably). The immediate reaction to this was a weaker Euro and a chorus of claims that this proves that central bankers are worried. I recommend looking more to the actual policies than the commentary. It is helpful to see the interest rate cuts.
The economic data was generally weaker than expected. This continues the pattern of sluggish growth we have seen for several months.
- Lower gasoline sales imply economic weakness. This is a tricky topic, since behavior changes with lower gas prices. Doug Short takes on all of the twists and turns and includes this helpful chart:
- Libor manipulation. The story describes actual effects as well as undermines confidence. This is an interesting interactive source that allows you to see what specific banks were doing at various times.
- The ISM manufacturing and services indexes both disappointed. Steven Hansen highlights the data as a "recession warning." We have (yet another) interesting chart from Doug Short, highlighting key points around recessions. Read the full article to see a similar treatment for the (shorter) service index history. Doug emphasizes the difficulty in drawing any firm conclusions, but see for yourself:
This week's "ugly" award is about employment, but it is unclear whom should be "honored."
For starters, I understand that the overall report was disappointing, mildly lower than expectations which had been somewhat elevated by the Thursday estimate from ADP. The discrepancy was well within the +/- 100K sampling error that is applied AFTER all revisions.
The ugly part of this comes from the attendant media coverage. Since the stock market declined after the announcement, most sources implied causation. PBS Newshour ran the employment and stock market stories together. In my comments at Wall Street All Stars my first reaction was that this was an "anti-Goldilocks" result, not bad enough to assure more QE from the Fed and therefore disappointing to traders. On CNBC that soon became the theme of the day. No one seemed to notice the dollar strength and euro weakness -- itself enough to account for a 1% decline.
The mistaken media interpretations are both a curse and an opportunity for individual investors. The emphasis on politics means that we can expect many stories about the terrible jobs situation. The facts:
The payroll jobs increase was weaker than expected, and far short of what is needed for a reduction in unemployment and a robust expansion. That pretty much sums it up.
The bright spots included gains in hours worked and the hourly wage. The household survey, thought better at capturing creation of jobs in small businesses, is much stronger than the payroll report. (Via Scott Grannis).
There are many with a major personal stake in making the economy look as bad as possible. It is difficult for most investors to remain objective.
The Indicator Snapshot
It is important to keep the current news in perspective. My weekly snapshot includes the most important summary indicators:
- The St. Louis Financial Stress Index.
- The key measures from our "Felix" ETF model.
- An updated analysis of recession probability.
The SLFSI reports with a one-week lag. This means that the reported values do not include last week's market action. The SLFSI has moved a lot lower, and is now out of the trigger range of my pre-determined risk alarm. This is an excellent tool for managing risk objectively, and it has suggested the need for more caution. Before implementing this indicator our team did extensive research, discovering a "warning range" that deserves respect. We identified a reading of 1.1 or higher as a place to consider reducing positions.
The SLFSI is not a market-timing tool, since it does not attempt to predict how people will interpret events. It uses data, mostly from credit markets, to reach an objective risk assessment. The biggest profits come from going all-in when risk is high on this indicator, but so do the biggest losses.
The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread." I'll explain more about the C-Score soon. We are working on a modification that will make this method even more sensitive. None of the recession methods are worrisome. Bob also has a group of coincident indicators. Like most of the top recession forecasters, he uses these to confirm the long-term prediction. These indicators are also not close to a recession signal.
There is a lot of activity from the recession forecasters. The basic summary is that those with the best records still see little chance of a recession in the next six months or so. The people that get featured in the press and on TV are sticking by their guns, even though the evidence is mounting against them.
We are now at the end of the nine-month forecast window that the ECRI adjusted to after their September, 2011 call (recession imminent, maybe already here, and unavoidable) seemed to prove wrong. Since then they have been adjusting indicators and trying to extend the window, which supposedly ends right now -- mid-year 2012. Last week we showed several good updates, repeated in case you missed them:
- The Bonddad Blog notes the failure of the ECRI forecast.
- Georg Vrba asks whether the ECRI is still relevant. Great analysis and charts.
- Doug Short has the latest economic forecasts. (look for the charts we have come to expect).
- Doug Short has an ongoing analysis of the ECRI call, including evidence from various sources. This is the single best source for updates, including a weekly chart of the ECRI leading index and comparison to other sources.
This week's recession news includes convincing evidence that the US is not in a recession:
- Dwaine Van Vuuren, drawing upon a range of great indicators, has an accurate assessment:
"We find ourselves in the 3rd “summer slowdown scare”, just like 2010 and in August 2011. During this time the perma-bears crank up the alarm bells and we are bombarded with a cacophony of ill tidings that spell the doom of the U.S economy. As we saw in 2010 and 2011 the economic slowdowns turned out to be “soft landings”. Investors scared into the side-lines stared in disbelief as the U.S stock markets roared ahead leaving them behind.
We may well be in the same position now. The permabears are coming out the woodwork."
- My one-stop source for understanding recessions. This will give you a big advantage since most people seem to go by "feel" rather than data. None of the best sources shows an imminent recession threat, and that is important for earnings. I am continuing to add to the recession series, reflecting some great research which is still in progress.
- Looking at the same indicators as the recession dating committee. The St. Louis Fed provides regular updates, so just save this link. To use it you must understand that a recession starts at a business cycle peak and includes a significant decline from that peak on four different measures. If you look at the chart, it is difficult to argue that we have seen a recent peak, not to mention a decline.
Nota bene - a slowing in the rate of growth is not a peak. This is the most common blunder of the pop-economist punditry.
Our "Felix" model is the basis for our "official" vote in the weekly Ticker Sense Blogger Sentiment Poll. We have a long public record for these positions. This week we continued as "bullish." These are 30-day forecasts.
[For more on the penalty box see this article. For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly ETF email list. You can also write personally to me with questions or comments, and I'll do my best to answer.]
The Week Ahead
I am not expecting much from the economic data next week, which is partly why I expect the emphasis to be on earnings.
Thursday's initial jobless claims will help to clarify whether last week's good result can be sustained. That was not part of the monthly employment survey period, so it will deserve special attention.
Normally the FOMC minutes do not provide much enlightenment, but I suspect that we might have a surprise this week. In the post-meeting press conference Bernanke dodged questions about the difference between projections and policy. He made a reference to the minutes. Most observers do not understand organizational behavior, so they might have missed this. The policy is the official organizational response. The projections are a collection of individual answers. We should be watching this with interest for a hint a future Fed policy.
We'll get data on consumer credit (Monday), the trade balance (Wednesday), PPI (Friday), and an update on Michigan sentiment. I am not expecting anything big from these sources.
Summary: Watch for a surprise on Wednesday, but mostly we'll be watching earnings.
Trading Time Frame
Our trading positions continued in fully invested mode last week. Felix is not a range trader, but is excellent at getting on the right side for big moves. The recent aggressive move is still showing a profit, and Felix is pretty aggressive.
Investor Time Frame
The successful investment strategy differs markedly from trading. It is especially important to establish good, long-term positions when prices are favorable. Most individual investors seriously underperform long-term results by selling low and buying high. Most successful professionals, of course, do the opposite.
This is easier said than done. With everyone on TV explaining with great confidence what just happened (please check out my article on the "message of the markets" it is easy for the average person to think he is out of step.
There is no magic moment. Resolving market worries is a process, not an event.
I tried to explain the most important concept for individual investors in this article about the Wall of Worry. I have had many emails from people who had a personal breakthrough in their investing when they understood this concept. If you missed it, I urge you to take a look. You can contrast this with the many pundits who claim miracles of market timing.
The best strategy through the various gyrations has been buying dividend stocks and selling calls for enhanced yield. Anyone unhappy with bonds should be doing this for a yield of 8-10% with greater safety than pure stock ownership. Take what the market is offering!
Final Thoughts on Earnings
We are in a multi-year period of improving earnings with lagging stocks. The explanation typically is that earnings cannot be sustained for one of several reasons:
- Profit margins are at a peak and will return to "normalized" levels. This has a great sound to it, but the implied reduction in productivity will be accompanied by more hiring. (See here).
- A recession is imminent.
- Europe or China is about to collapse.
Meanwhile, none of the data has ever supported these arguments, which remain completely theoretical. Brian Gilmartin, writing in his new blog Fundamentalis, explains it very well:
"Coming into the start of q2 ’12 earnings from Alcoa on July 9th, expectations are very subdued, and the growth outlook is modest at best, so even if guidance is tepid and warnings are rampant, unless you have a portfolio of high p/e growth stocks, chances are a lot of downside is already built into the market."
Check out the entire article to see his analysis of the history of the regular "bumps" in forward earnings, something that you will not read anywhere else.
A Final Thought about Europe
A year ago the argument was that Europe banks and nations would fall like dominoes with a risk to the entire financial system. With the most dire of consequences averted, the argument now is that Europe will drag the entire world into a recession. Before falling for this idea, investors should consider this wisdom from Charles Lieberman:
"Recession in Europe has only a modest effect of domestic growth. Exports account for about 13% of U.S. GDP, Europe accounts for just 20% of U.S. exports and a sharp recession in Europe might lower their GDP by maybe 3%. So the impact of a recession in Europe on domestic growth is 13% times 20% times 3% of GDP, a miniscule number. The real risk was that of a meltdown of their credit markets, which might also cause our credit markets to freeze up. This was considered a severe risk, since memories of the credit freeze of 2008 are sufficiently fresh. Still, such an event requires that European leaders would fail to address the problems and would allow them to fester until they explode. Such an outcome was possible, but not overly likely. Once again, European leaders have stepped up to relieve the pressures."
About the Author
Jeff Miller has been a partner in New Arc Investments since 1997, managing investment partnerships and individual accounts. He has worked for market makers at the Chicago Board Options Exchange, where he found anomalies in the standard option pricing models and developed new forecasting techniques. Jeff is a Public Policy analyst and formerly taught advanced research methods at the University of Wisconsin. He analyzed many issues related to state tax policy and provided quantitative modeling which helped inform state and local officials in Wisconsin for more than a decade. Jeff writes at his blog, A Dash of Insight.